Digest of Recent Important Foreign Decisions on Cross- Border Taxation — part II

The Supreme Court recently issued a judgment that the marketing fee paid by a Thai franchisee would be subject to Thai withholding tax as the fee constituted royalty income.

In a typical international franchise scheme, the foreign franchisor would charge the Thai franchisee a franchise fee, which typically consists of a royalty for the intellectual property and a marketing fee. It is common practice for the franchisor to ensure that any marketing activity undertaken by the franchisee is in line with the franchise’s international standards, and for the marketing fee to be computed based on net sales.

From a tax perspective, there remains no question that the franchise fee is categorised as royalty income, which would be subject to Thai withholding tax at the rate of 15% u/s. 70 of the Revenue Code. However, the marketing fee incurred by the Thai franchisee via payments made to Thai advertising companies had largely gone unnoticed for Thai withholding tax purposes.

The Supreme Court has now held that marketing fees paid in Thailand to Thai advertising firms would be subject to 15% Thai withholding tax as royalty, as if it had been paid to the foreign franchisor. The Court based the judgment on the following:

— the fee is deemed to be the additional income of the franchisor, as it directly, or indirectly, benefits the brand as well as the trademark of the franchisor;

— the franchisor effectively has control over the advertising activities; and

— this fee is calculated in a similar manner to franchise fee, i.e., based on sales.

It appears that the Court has ruled in this manner so as to prevent tax planning by a foreign company (which was not carrying on any business in Thailand) from avoiding withholding tax u/s. 70 of the Revenue Code.

This judgment is expected to have a huge impact on audits carried out by revenue officers with revenue officers raising more assessments on the franchisee in Thailand for past payments.

14. United Kingdom: Determination of residence for individuals

Court of Appeal rules on HMRC’s interpretation of IR20
On 16th February 2010, the Court of Appeal dismissed applications for judicial review in the cases of R (oao Davies and anor) v. CRC; R (oao Gaines- Cooper) v. CRC.

The taxpayers sought judicial review of HMRC’s determination that they were resident and ordinarily resident in the United Kingdom.

(a) Facts and legal background. The issue centred on guidance published by HMRC on residence and ordinary residence of individuals, known as IR20.

Paragraph 2.2 of IR20 provided that a taxpayer would be treated as non-resident and non-ordinarily resident if:

— he left the UK for the purposes of full-time employment abroad;

— he remained abroad for at least a whole tax year, and

— his visits to the UK totalled less than 183 days in any tax year, and averaged less than 91 days per tax year.

Paragraphs 2.7 to 2.9 of IR20 dealt with ‘Leaving the UK permanently or indefinitely’. Thereunder, HMRC reiterated the 91-day rule mentioned above. That section also stated that HMRC might request evidence of permanent abode outside the UK.

The taxpayers had left the United Kingdom, but not for the purposes of employment abroad. As such, their situation fell under IR20 paras 2.7.-2.9, and not IR20 para 2.2.

HMRC issued a determination that the taxpayers were resident in the United Kingdom, on the basis that they had not made a ‘distinct break’ from ties in the United Kingdom. Thus, it was not sufficient for the taxpayers simply to meet the 91-day rule.

The taxpayers argued that the ‘distinct break’ requirement was contrary to the guidance in IR20. They argued further that even if the requirement were found to be in line with the guidance, HMRC had, in practice, previously not insisted on this requirement. The fact that HMRC only began to require such evidence in 2004-05 amounted to a change in approach, and this breached their legitimate expectations.

(b) Issue. The issues were:

— whether, in requiring evidence of a distinct break, HMRC had departed from the terms of IR20, and

— even if HMRC had not so departed, whether HMRC had changed their approach, leading to a breach of the taxpayers’ legitimate expectations.

(c) Decision. IR20 para 2.2. dealt with leaving the United Kingdom for the purposes of full-time employment abroad. Under this paragraph, there was no requirement for a ‘distinct break’. Thus, for individuals who came within the terms of that paragraph, there was no need for HMRC to look into any persisting social or family ties in the UK.

The Court rejected the taxpayers’ argument that this interpretation should also apply to IR20 paras 2.7-2.9. According to the Court, because IR20 paras 2.7-2.9 deal with leaving the United Kingdom ‘permanently or indefinitely’, these words are crucial in terms of construing those paragraphs. It is therefore important to consider the extent to which the taxpayer has retained social and family ties within the United Kingdom.

There is therefore a clear distinction between the determination of residence for individuals who have left the UK for full-time employment abroad, and those who have left the UK permanently or indefinitely.

The taxpayers fell within IR20 paras 2.7-2.9, and therefore HMRC was entitled to request from them evidence of having left the United Kingdom ‘permanently or indefinitely’, and this included evidence of a ‘distinct break’.

On the change of approach point, Moses LJ stated that there was no public law obligation of fairness that prevents HMRC from increasing, without warning, the intensity or scrutiny of claims by taxpayers to be non-resident. Indeed, the absence of warning might be a powerful tool to deploy, to ensure that taxpayers provide frank disclosure. Nevertheless, the Court held that HMRC’s rejection of the taxpayers’ claim was not as a result of a changed approach. The appeals were dismissed.

Ward LJ, while agreeing with the decision, nevertheless, expressed some sympathy for the taxpayers. He understood the taxpayers’ suspicions that HMRC had indeed changed their policy. However, he was persuaded that what has been construed to be a change in HMRC policy was actually the effect of a closer and more rigorous scrutiny and policing of a growing number of claims. This is permissible for HMRC to undertake, and is not a root-and-branch change in policy.

Note: In 2009, IR20 was withdrawn and replaced by new guidance document, HMRC6.

15. France: Administrative Supreme Court clarifies notion of domicile for individuals

On 27 January 2010, the Supreme Administrative Court gave its decision in the case of SCP Vier (No. 294784) concerning the domestic notion of fiscal domicile. Details of the decision are summarised below.

(a) Legal background. Domestic law treats individual taxpayers as residents for tax purposes when they have their fiscal domicile in France. The definition of fiscal domicile, provided by Article 4B of the Code Général des Impôts (CGI), is based on three alternative criteria:

— personal: the home or principal place of residence; or

— professional: performance of a trade, business or professional activity; or

— economic: the centre of the economic interests.

Under the economic criterion, an individual is considered to have the centre of his economic interests in France, if the individual:

—  has made major investments;

— has a main office or effective place of management; or

—  derives most of his income in France.

(b)    Facts. The taxpayer possessed immovable and movable assets situated in France, while his regular income was derived from an employment in Greece. After a tax investigation, the French tax authorities decided to assess the taxpayer as a French resident on his worldwide income. They took the position that due to the location of his assets, the taxpayer met the economic criteria provided by Article 4B1(c) of the CGI: the ‘centre of its economic interests’. The taxpayer claimed not to be a resident and, thus, only liable to French source income.
    
(c)    Issue. The issue was whether the notion of ‘centre of economic interests’ should be considered as (i) the place where the individual has made major investments, regardless of their profitable nature; or (ii) the place where the individual derives most of his actual income.

(d)    Decision. The Administrative Supreme Court ruled in favour of the taxpayer and held that the notion of ‘centre of economic interests’ refers primarily to the place where an individual derives most of his income. Thus, the location of the assets must be regarded as a secondary criterion in the definition of ‘centre of its economic interests’.

16.    United States: Transfer Pricing:

US Court of Appeals withdraws decision in Xilinx transfer pricing case

The US Court of Appeals for the Ninth Circuit has withdrawn its decision in the case of Xilinx Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue, (Docket No. 06-74246). See TNS:2009-06-05:US-1.

The decision was issued 27th May 2009 and held that the specific rules for cost-sharing agreements (CSAs) in the US Treasury Regulations issued u/s. 482 of the US Internal Revenue Code prevailed over the general arm’s-length standard.

As a result, the value of stock options granted by Xilinx in connection with a CSA were required to be included in the pool of costs to be shared under the CSA even when the facts indicated that companies operating at arm’s length would not do so. The Court of Appeals also determined that this result did not violate the provisions of the 1997 US-Ireland income tax treaty due to the saving clause in Article 1(4).

The decision of the Court of Appeals, which was by a 2:1 majority of a three-member judicial panel, proved controversial, and the taxpayer petitioned the Court for re-hearing (see TNS:2009-08-18:US-1) . The Court’s Order withdrawing the decision is dated 13th January 2010. It does not indicate the next step to be taken in the proceeding.

17.    Spain: Substance v. Form

Treaty between Spain and US-Spanish Supreme Court takes substance over form in approach applying treaty

The Supreme Court gave its decision on 25th September 2009 in the case of the sale of shares of the Spanish company La Cruz del Campo, S.A. owned by US Stroh Brewery Company to Guinness Plc (Recurso de Casación 3545/2003). Details of the decision are summarised below.

(a)    Facts. The appellant, Stroh Company, held shares representing 28.45% of the capital of La Cruz del Campo, S.A. In January 1991, Stroh accepted the offer by Guinness Plc to buy those shares. It also told the buyer that it would exercise the transfer in several steps. At the time of the offer, the shares were deposited in the United States. In January 1991, Stroh transferred part of the shares to its US subsidiary, Victors Company, in exchange for 17 shares in the latter. Victors Company sold the shares to Guinness Plc for the same price as that for which it had acquired them. In May 1991, Stroh transferred the remaining shares in La Cruz del Campo S.A. to another US subsidiary, Hoya Ventures, in exchange of 100% in the latter’s capital. These shares represented less than 25% of the capital in La Cruz del Campo, S.A. The shares were sold by Hoya Ventures to Guinness Plc in February 1992 for the same price as that for which it had acquired them. The tax administration and the decision of the First Instance Court considered that the capital gain of the sale was obtained by Stroh, and was therefore taxable in Spain.

(b)    Issue. Spanish corporate income tax legislation at the time of transactions considered income derived from securities issued by Spanish resident companies to be taxable in Spain, but the law only expressly taxed capital gains derived from assets located in Spain. Therefore, the appellant claimed that Spain did not have taxing rights on the transaction.

Article 13(4) of the USA-Spain tax treaty states that gains derived from the alienation of stock in the capital of a company resident in a contracting state may be taxed in this state if the recipient of the gain during the 12 -month period preceding the alienation had a participation, directly or indirectly, of at least 25% of the capital. Item 10(c) of the protocol to the treaty establishes an exception to the taxation of an alienation when the alienations are contributions between companies of the same group, and the consideration thereof consists of a participation in the capital of the acquiring company.

The appellant considered that there was a breach of the tax treaty since the tax administration and the First Instance Court decision qualified as ‘sales’ the transactions that were non-monetary contributions to the capital of the subsidiaries, which were excluded from taxation by the protocol. In addition, the interpretation of an international convention could not be undertaken unilaterally by one of the parties. Moreover, the second transaction entailed less than 25% of the capital, so it could have only been taxable in the United States. Furthermore, in case the transactions were subject to tax in Spain, the taxable capital gains should be those obtained by the subsidiaries from the difference between the selling price and the acquisition cost. In this case, there was no difference between the two.

(c)    Decision. The Supreme Court held that as the company issuing the shares was resident in Spain and the shareholder’s rights should be exercised in Spain, the shares should be considered as being located in Spain independently of where the shares were deposited. Therefore, the capital gain was subject to tax in Spain.

The Court stated that the person applying the law must qualify any act or transaction in accordance with its real juridical nature, bearing in mind its content, consideration and legal effects, without following the forms or names given by the parties. Therefore, both the tax administration and the Court of First Instance were allowed to qualify the transactions when those transactions did not correspond to the true legal nature of the considerations.

At the time of acceptance of the offer, Stroh fulfilled the two requirements established in Article 13(4) of the treaty, which allow the transaction to be taxed in Spain. The purpose of the subsequent share transactions with the subsidiaries was not for restructuring reasons. When examining the transactions involved as a whole, it appeared
that the intention of the appellant was not the one that is usually assigned to these types of transactions.

Therefore, there was a relative contractual simulation that occurs when there is an (unwanted) fictitious transaction aimed at disguising the real transaction (that was made in breach of the law). The effect of the law is to reveal the legal implications that the parties had tried to avoid. Therefore, the Court concluded that the tax administration was correct in its assessment.

18.    Australia: Foreign Tax Credit

ATO Interpretative Decision ATO ID 2010/175 — FTC for foreign tax paid in respect of gain not fully assessable in Australia

On 8 October 2010, the Australian Taxation Office (ATO) issued an Interpretative Decisions (ATO ID).

ATO ID 2010/175 deals with the entitlement to a foreign income tax offset (i.e., foreign tax credit) for a foreign tax paid in respect of a gain where the gain is not fully assessable in Australia. The ATO reached a decision that based on the wording of the legislation, only a proportion of the foreign tax should be available as a credit. Interestingly, the ATO ID notes a statement in Explanatory Memorandum to the Bill implementing the new foreign tax credit rules that seems to suggest that a full credit should be available. The ATO expressed its view that the statement is inconsistent with the words and purpose of the legislation and should be disregarded.

19.    United States; France: Foreign Tax Credit

Treaty between US and France-US Tax Court: income earned in or over foreign countries; US or international airspace (saving clause, foreign earned income exclusion, FTC)

The US Tax Court has decided on the availability of the foreign -earned income exclusion and foreign tax credit with regard to a flight attendant’s income. Savary v. Commissioner of Internal Revenue, T.C. Summary Opinion 2010-150, Docket No. 6839-09S (6 October 2010).

The case involved a taxpayer who was a US citizen but resident of France. She worked as a flight attendant on flights between France and the United States:

— 38.2% of her income was earned in or over for-eign countries (the ‘foreign income’); and

— the remaining portion was earned while in the United States or in international airspace (the ‘US/international airspace income’).

US-France tax treaty

The first issue was whether the United States was precluded from taxing her income by Article 15(3) of the treaty between the United States and France signed on 31st August 1994 (the ‘Treaty’), which provides that income from employment as a crew member of a ship or aircraft operated in international traffic is taxable only by the country of which the taxpayer is a resident.

The Tax Court held that the saving clause in Article 29(2) of the Treaty, which provides that the United States may tax its citizens and residents as if the Treaty had not come into effect, took precedence and thus her income was taxable under the Internal Revenue Code (IRC).

Foreign earned income exclusion

The second issue was whether the taxpayer was entitled to claim the foreign-earned income exclusion under IRC section 911.

The Tax Court concluded that the ‘US/international airspace income’ was US source income and not foreign-earned income, noting that international airspace is not a foreign country for purposes of IRC section 911.    Accordingly, the taxpayer was not entitled to claim the foreign-earned income exclusion.

On the other hand, the taxpayer was allowed to exclude the ‘foreign income’.

FTC:

The third issue was whether the taxpayer was entitled to a foreign tax credit in the United States under Article 24 of the Treaty and IRC section 901 for the taxes paid to France.

The Tax Court denied a US credit for US tax payable on the ‘foreign income’, on the ground that the taxpayer was already allowed a US exclusion of such foreign source income under IRC section 911.

Further, the Tax Court disallowed a US credit for French tax paid on the ‘US/international airspace income’, explaining that the United States consented in Article 24 only to provide a FTC on income attributable to sources in France, as determined under the source of income rules of the IRC, and not to US source income. The Tax Court stated that a credit in France would be the only treaty relief from double taxation. The Tax Court noted that the French tax authorities had already denied the credit on the basis of Article 15(3) of the Treaty. The Tax Court was of the view, however, that the French tax authorities had erred in this regard, and that the taxpayer could seek reconsideration from the French authorities or, as a last resort, competent authority relief under Article 26 of the Treaty.

Accuracy-related penalty:

The fourth and final issue was whether the tax-payer was liable for the accuracy-related penalty under IRC section 6662.

The Tax Court declined to impose the penalty be-cause it was not demonstrated that the taxpayer’s underpayment was attributable to her negligence or disregard of rules or regulations.

20.    Italy: Beneficial Owner

Treaty between Italy and Luxembourg — Italian decision on interpretation of term ‘beneficial owner’

On 19 October 2010, the Lower Tax Court of Piemonte (Commissione tributaria provinciale del Piemonte/Torino) issued decision no. 124 regarding the interpretation of the term ‘beneficial owner’ contained in Article 12 (Royalties) of the tax treaty between Italy and Luxemburg (the Treaty). Details of the decision are summarised below.

(a)    Facts. The taxpayer is an Italian company that signed an agreement for the use of a trademark owned by a Luxemburg company (Luxco). Luxco is wholly owned by a company resident in Bermuda.

On the royalties paid by the Italian taxpayer to Luxco, the reduced withholding tax (10%) provided for by Article 12 of the Treaty was withheld instead of the domestic withholding tax of 30%.

The Italian tax authorities claimed that Luxco was not the beneficial owner of the royalty’s payment; therefore, it cannot benefit from the reduced with-holding tax provided for by the Treaty.

(c)    Decision. The taxpayer asserted that Luxco was the beneficial owner of the royalties payments based on the following grounds:

— Luxco was the owner of the trademark, which was accounted for in Luxco’s annual balance sheet;

— the trademark was properly registered in Luxemburg;

— the use of the trademark was granted by a proper licence agreement between the Italian taxpayer and Luxco;

— the income generated by the licence agree-ment was properly accounted for in Luxco’s profit and loss accounts.

The Court noted that the arguments put forward by the taxpayer only prove that Luxco was the formal owner of the trademark and that it formally received the royalty payments, but not that Luxco was the beneficial owner. Therefore, the Court rejected the arguments of the taxpayer, giving the following reasons:

— The beneficial owner must have an autonomous organisation to provide services and must bear the entrepreneurial risks of such activity. This was not the case in respect to Luxco. Indeed, Luxco acquired the trademark free of charge and it has no costs related to such trademark; moreover, Luxco had a very small operative organisation (no movable properties, low employment costs). In this respect, Luxco is acting without any entre-preneurial risks.

—  Luxco was wholly owned by a sole shareholder (resident in Bermuda).

21.    Finland: Transfer Pricing

Supreme Administrative Court rules on interest rate on intra-group loan

The Supreme Administrative Court of Finland (Korkein hallinto-oikeus, KHO) gave its decision on 3 November 2010 in the case of KHO:2010:73. Details of the decision are summarised below.

(a)    Facts. As part of restructuring the financial structure of a group, the taxpayer, Finnish company A Oy, paid back two loans taken from a third party and took a corresponding loan from a Swedish company B AB, which was acting as the group financing company. The loans taken from the third party carried interest at the rates between 3.135% and 3.25%, whereas the interest rate on the intra-group loan was set to 9.5% based on the average group interest rate. The average group interest rate was determined by interest rates applied on loans that the group had taken from third parties and loans from its shareholders.

(b)    Legal background. Affiliated companies are required to observe the arm’s-length principle. If the tax authorities conclude, based on section 31 of the Law on Tax Procedure, that the arm’s-length principle has not been observed in transactions between group companies, the taxation may be corrected and reassessment may be made to re-flect the arm’s-length conditions.

(c)    Issue. The issue was whether the interest rate set on the intra-group loan, 9.5%, was at arm’s length, considering that the loans taken from a third party had been subject to interest rates of 3.135% and 3.25%.

(d)    Decision. The Court emphasised that the interest rate on an intra-group loan cannot be based on an average group interest rate in circumstances (e.g., the company’s good creditworthiness) where financing could have been obtained from a non-related party at a substantially lower interest rate than the average group interest rate. The Court pointed out that the taxpayer’s financing needs did not substantially change in the refinancing and it had not received any financial services from B AB which may have influenced the interest rate.
The Court held that the interest rate on the intra-group loan was not at arm’s length and increased the taxpayer’s taxable income by the amount of non-deductible interest which was the difference between the interest rate on intra-group loan (9.5%) and the interest rate of 3.25%.

United States: Residency

USVI District Court denies residency for lack of intent to become USVI residents

The US District Court of the United States Virgin Islands (USVI) has determined that five family members were not bona fide residents of the USVI on the ground that they failed to demonstrate their genuine intent to become USVI residents. VI Derivatives, LLC v. United States, Case No. 3:06-CV-12 (18 February 2011).

This case involved five members of the Vento family — Richard Vento (husband), Lana Vento (wife), Nicole Mollison (daughter), Gail Vento (daughter), and Renee Vento (daughter). They filed their income tax returns with the USVI Bureau of Internal Revenue (BIR) in 2001. Both the BIR and the US Internal Revenue Service (IRS) issued Notices of Deficiency to the Vento family. Each Vento family member filed a petition to determine their income tax liability for 2001 and their petitions were con-solidated into this case.

The Vento family took the position that they were exempt from US taxation on the income reported in the USVI u/s. 932 of the US Internal Revenue Code (IRC) because they were present in the USVI on the last day of 2001 with intent to become residents. The BIR contended that the petitioners’ pattern of repeated travel to the USVI and their development of a residential property was sufficient to establish USVI residency. The IRS argued that the petitioners were not bona fide residents of the USVI, because they did not take sufficient action to demonstrate an intent to become USVI residents and did not abandon their prior residences by the end of 2001.

The District Court stated that under IRC section 932, as applied in 2001, a taxpayer who was a bona fide resident of the USVI at the end of a year generally was exempt from filing a US federal income tax return or paying income taxes to the United States for that year. The District Court further stated that IRC section 932, however, drew a distinction between a bona fide residents and mere transients or sojourners, and required the latter to file a tax return with both the IRS and the BIR for income received from the USVI.

The District Court noted that both parties agreed the standard set forth in Sochurek v. Commissioner, 300 F.2.d 34 (7th Cir. 1962) should be applied in deciding whether the Vento family members were bona fide USVI residents at the end of 2001.

The District Court further noted that while the abandonment of a prior residence is not required to claim residency elsewhere, a court may consider whether a taxpayer maintains strong ties to a location other than the claimed residence.

The District Court stated that the subjective Sochurek factors — whether the petitioners intended to be USVI residents at the end of 2001 or whether they travelled to the USVI for the purpose of avoiding US income taxes — had particular relevance, given the suspicious timing of the family’s decision to ‘move’ to the USVI. The District Court noted that in early 2001, the family realised a gain of USD 180 million from the sale of their shares in a technology business (Objective Systems Integrators, Inc.), of which Richard Vento was a founder, and that the USVI residency for 2001 would allow them tax savings of more than USD 9 million.

The District Court held that the Vento family’s testimony that they intended to become USVI residents by the end of 2001 was undermined by the objective facts:

— the house they purchased in the USVI was not liveable by the end of 2001, despite efforts to renovate it as quickly as possible;

— the house was not fully furnished by the end of 2001;
—  none of the family’s furniture or valuable personal possessions were brought to the house;

—  the family spent very little time in the USVI during 2001 and 2002 and primarily engaged in vacation-type activities when in the USVI;

— the family did not have a bank account in the USVI in 2001;

— neither of the two businesses Richard Vento was starting in the USVI was up and running by the end of 2001;

— there is no evidence that Richard and Lana Ventos were involved in community activities in the USVI or had assimilated into its culture in 2001;

—  the family’s office remained in Nevada;

— Richard and Lana Ventos purchased property in Nevada in May 2001 with a plan to construct a mansion on the property;

— Nicole Mollison’s children were enrolled in school in Nevada in 2001; and

—  in 2001, Gail Vento was attending college in Colorado, and Renee Vento had a clear goal of obtaining a master’s degree in California.

After applying the relevant Sochurek factors, the District Court concluded that no member of the Vento family was a bona fide resident of the USVI at the end of 2001.

Acknowledgment/Source

We have compiled the above summary of decisions from the Tax News Service of the IBFD for the period April, 2010 to March, 2011.